Are stocks cheap yet? Not if the economy is slowing, these numbers say

Trying to figure out whether the U.S. stock market after the stunning decline of the last month is a bargain or not?

James Mackintosh’s “The Short View” column in today’s (August 23) Financial Times lays out in very clear terms one way to answer the question.

After a month of selling the Standard & Poor’s 500 Stock Index trades at just 10.3 times projected earnings. That’s below the forward price-to-earnings ratio in March 2009, the post-Lehman Brothers bottom. (The average since 1985 is 15.)

But that’s only cheap, Mackintosh points out, if projections for future earnings are accurate.

Right now forecasts by Wall Street analysts are calling for earnings of $108 a share for the 500 stocks in the S&P index. That’s higher than earnings on the index in 2007.

But in 2008 forecasts (and then actual earnings) plunged as the economy fell into recession.

A similar drop to that from 2007 to 2008 in today’s forecast earnings—which is what investors could expect if the U.S. economy dipped back into recession--would put the S&P 500’s price to earnings ratio at 17. That’s not cheap but rather expensive in comparison to the long-term average of 15 since 1985.

A 20% drop in forecast earnings—the rough equivalent of an economic slowdown instead of a recession—would put the price-to-earnings ratio of the S&P 500 at 13. That’s below the average of 15 but not really very cheap given the degree of economic risk that an investor is taking on right now.